That explains why the top U.S. stock index is now 30 percent higher than it was just before this virus hit in early 2020 – although the U.S. economy has not yet fully recovered from successive Covid lockdowns. And wherever the Fed goes, the other big central banks – not least in the euro zone and the UK – will follow suit and continue to print virtual money like Billyo.
For a decade there has been a huge gap between financial markets and the real world, explained by increasing incentives. And as central banks generate new money to buy government debt, which then fund government spending, the distinction between monetary and fiscal support is seriously blurred.
The Fed added $ 3 trillion (£ 2.1 trillion) in QE to its balance sheet in 2020 – similar to its overall monetary expansion in the decade after 2008. The Bank of England numbers are relatively similar after adding £ 425 billion in Pre -Covid. QE released until 2019, with the total number having more than doubled since the lockdown began last year.
The combination of extremely low interest rates and the generosity of central banks has resulted in global corporations selling a record $ 4.4 trillion corporate bonds in 2020. Huge government spending has also been effectively funded through an extra-large wave of QE.
While this decade-long monetary tsunami created “feel good” bubbles in the equity and bond markets, QE has had very negative distributive effects – it makes those who already own assets much richer.
And the much higher debt burden that has accumulated over the past ten years, but especially last year, will now hold back medium-term growth – government and corporate balance sheets are much more exposed to the risk of rising interest rates. And then there is the risk that efforts to loosen or even slow QE could lead to another nasty collapse if the prices of bloated financial assets collapse.
It is critical now that we avoid inflation expectations adjusting before central banks do. In other words, policymakers must step off the gas and begin pulling back on ongoing incentives as interest rates gradually increase before fears of higher inflation affect corporate pricing and become a self-fulfilling prophecy.
A nasty rise in inflation would destroy business confidence and make investment difficult, leading to “stagflation” – when the economy stagnates and living standards erode while unemployment rises. The central banks would then be forced to hike rates sharply, which would incur enormous, very painful adjustment costs, as inflation would be pushed out of the system, as the history of the 1970s and 1980s shows.
It can be too late. The bond markets “price in” inflation even though central banks use QE to buy up large portions of government debt, effectively manipulating the market. The 10-year US Treasury yield is up from 0.51 percent last year to 1.75 percent, although it has declined somewhat recently due to further Fed intervention. The UK 10-year gilt yield rose from 0.2 percent to 0.8 percent in 2021 – still low, but a huge increase in relative terms.
Because there is evidence of inflation everywhere. Oil prices rose 80 percent last year – when the world economy started up again. Food inflation is rising rapidly, with global wholesale crop prices rising an extraordinary 40 percent in May compared to the same month last year.
